China’s onshore bond yields have risen sharply since late 2016 when bond prices started dropping due to inflation fears fuelled by a rebound in both commodity prices and the Producer Price Index (PPI).

The Chinese bond sell-off was part of the global reflation trade as global bond yields also rose.

In February this year, the rise in onshore bond yields received further impetus from domestic factors, when the People’s Bank of China (PBoC) embarked on selective monetary tightening.

In March, Beijing began to impose tighter regulations aimed at forcing the onshore wholesale funding market to reduce its debt levels.

These factors have led Chinese bond yields to continue to rise even as global bond yields have stabilised or fallen.

We anticipate China’s onshore yields rising further in the near term as the financial crackdown to reduce systemic risk may force more selling by non-bank financial institutions (NBFIs). Should that occur, the resultant liquidity squeeze would likely further slow overall credit growth (see Exhibit 1 below). The financial clamp-down has also sharply reduced fundraising in the bond market, especially by Chinese enterprises (Exhibit 2), so the slowdown in bond issuance could continue in the near term. Overall, however, this has not caused major funding problems, largely because bank loan growth has picked up and offset some of the wholesale funding squeeze.

Exhibit 1: Regulatory tightening causing a slowdown in overall credit

Source: CEIC, BNP Paribas Asset Management (Asia), as of 17/07/2017

The financial clamp-down has also sharply reduced fundraising in the bond market, especially by Chinese enterprises (see Exhibit 2), so the slowdown in bond issuance could continue in the near term. Overall, however, this has not caused major funding problems, largely because bank loan growth has picked up and offset some of the wholesale funding squeeze.

Exhibit 2: Bond issuance in China has dropped

Note: * incl. govt., financial and enterprise bonds

Source: CEIC, BNP Paribas Asset Management, as of 17/07/2017

Should China’s GDP growth momentum ease from a robust 6.9% year-on-year (YoY) in the first quarter of 2017 towards 6.5% YoY as we are expecting in the run-up to the 19th Communist Party Congress this autumn, Beijing will likely ease up on its selective liquidity and regulatory tightening measures.

Meanwhile, foreign investors’ exposure to the Chinese fixed-income market has remained very low, accounting for less than 2% of the total USD 9 trillion outstanding debt. Beijing has gradually been opening up the onshore bond market to foreign participation by expanding the Qualified Foreign Institutional Investor (QFII) programme, allowing foreign official institutions free access to the China interbank bond market (CIBM) since June 2015, and allowing foreign institutional investors to access the CIBM since February 2016. Recently, it has sanctioned the Bond Connect programme, modelled on the Stock Connect schemes, for foreign institutional investors to invest and trade in the CIBM without having to apply for quotas and open onshore accounts.

It seems that both macroeconomic and regulatory factors are converging to create a positive environment for China’s onshore bond market. The forced selling by domestic players due to the financial crackdown has, arguably, made onshore yields attractive, while the spread between Chinese government bonds and US Treasuries widened sharply (Exhibit 3). The crackdown has likely run its course, with liquidity probably easing soon. Structurally, the CIBM is a market predominantly denominated in local currency and is invested in by local investors, thus shielding China against a debt-currency crisis that pessimistic observers have predicted for many years but still has not happened.

Exhibit 3: Yield spread between 10-year Chinese government bond and US Treasury

Source: CEIC, BNP Paribas Asset Management (Asia), as of 17/07/2017

For foreign investors, a critical factor that hit Chinese bond returns last year was the 8% drop in the renminbi against the US dollar. But renminbi foreign exchange risk has now retreated because of fading capital outflows from China due to improving Chinese fundamentals and US dollar weakness. If the renminbi appreciates against the US dollar later this year, as I have previously argued, it would add to the attractiveness of the CIBM (see Exhibit 4).

Exhibit 4: Chinese bond yield topping out?

Source: CEIC, BNP Paribas Asset Management (Asia), as of 17/07/2017

Written on 17/07/2017

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